The Fed Walks a Tightrope

April 24, 2008 • Commentary
This article appeared in the Washington Post on April 24, 2008.

When the Federal Reserve’s Federal Open Markets Committee meets next month, the foremost topic of conversation is likely to be whether to continue lowering interest rates. Since last September, the Fed has reduced the federal funds rate by 3 percentage points — a large change by historical standards.

The decisions to make these rate cuts have not been unanimous, which raises the question: Why? To answer that question, we must understand the Fed’s role and its past policy decisions.

Congress has given the Federal Reserve two sometimes conflicting mandates: It should maximize economic growth and restrain inflation. The former apparently requires low interest rates; the latter, high ones. Walking that tightrope gives currency to the old saying that the Fed should “take away the punchbowl before the party really gets going.”

As we learned in the 1970s, high inflation — and expectations of high inflation — can devastate the economy. Low inflation — and expectations of low inflation — mean stable wages, interest rates and prices, all of which tend to encourage work, innovation and production.

The Fed’s strategy 1980s and ‘90s earned it considerable credibility as an inflation fighter. But the Fed has been less successful in responding to negative supply shocks, such as spikes in oil prices, that raise firms’ production costs and increase the risk of overall inflation. In response, firms must make structural adjustments — eliminate unprofitable products and change technologies to minimize cost increases. Those changes are often painful, especially for displaced workers.

In the past, the Fed responded to oil shocks by tightening the money supply, but that often led to recessions. Yet if the Fed had reduced interest rates to prevent oil‐​shock‐​induced output losses, it would have risked higher inflation.

The Fed’s past decisions to opt for money tightening probably reflected an extreme anti‐​inflationary bias at a time when memory of the 1970s’ “great inflation” was still fresh. That memory seems fainter and less influential today, given the Fed’s dramatic interest rate cuts in the wake of climbing oil prices.

In the Fed’s defense, the current economic situation involves more than just an oil supply shock; the housing sector has weakened and the financial markets are suffering liquidity shortages. Declining home prices reflect over‐​investment in houses, which compounds the negative oil price shock with a negative shock to Americans’ wealth and spending. Depreciating home values also cause lopsided bank balance sheets with too many non‐​performing loans eroding bank capital. Those capital losses are triggering cutbacks in lending to viable borrowers who, in turn, reduce spending on consumption and investment.

This leaves the Fed with lousy choices. If it tightens the money supply in order to combat inflation, the supply shock‐​induced decline in the nation’s output may accelerate. But if it increases liquidity for financial institutions, it may trigger higher inflation in the future. Indeed, inflation rates have been ticking up since November.

So far, the Fed has appeared willing to run the risk of inflation in order keep the economy buoyed. But should it pursue that policy much further? Two arguments suggest that the FOMC should refrain from additional rate cuts, at least for now:

First, the credit market problems cannot be solved by traditional interest rate cuts. They ultimately require an infusion of capital in affected institutions, and that is a fiscal and not a monetary issue.

Second, output losses from structural adjustments are unavoidable. Sooner or later, we must shift our investment from housing to energy, and that shift will not be painless. Loose monetary policy might induce households and business to postpone making those changes — but that will prolong and perhaps increase the total amount of economic pain.

The FOMC’s policy disagreements over interest rates reflect its members’ different perceptions and preferences about how quickly such adjustments should be promoted via monetary policy. We worry that further delays induced by excessively accommodative policy will result in a vicious cycle of higher inflation, increased inflation expectations, reduced Fed anti‐​inflationary credibility, slower capital reallocations and, eventually, a weaker economy.

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